Changes in Inventories and the Lemonade Stand

In our lemonade stand example, inventories (lemons and paper cups) decreased from $20 at the beginning of 2007 to $0 at the end of the year.

During the year, you recorded COGS of $20 on the income statement (all inventories were converted into COGS and used up in the making of lemonade, which was subsequently sold). However, you did not spend any cash on lemons and paper cups during the year since you purchased them before the start of 2007.

Accordingly, decrease in inventories of $20 during the year must be added back to net income (Exhibit 7.10) on the cash flow statement in order to accurately depict the amount of cash generated by the company’s operations.

Exhibit 7.10. Decrease in Inventories Has a Positive Cash Impact and Must Be Added Back to Net Income to Arrive at Cash Generated by Operating Activities

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